First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Price Discrimination
E. Glen Weyl
University of Chicago
Lecture 10
Regular Section
Elements of Economic Analysis II
Fall 2011
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Introduction
Key assumption of last lecture was uniform pricing
Everyone pays same for ever unit of the good
Drawn from competitive market, where it makes sense
Same marginal cost of production, so competition drives
Much less obvious with a monopoly
=⇒ Today we’ll explore many alternative ways of pricing
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Perfect or first-degree price discrimination
Second-degree or quantity-based price discrimination
Also, related, quality-based price discrimination
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4
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Third degree or identity-based price discrimination
Other common forms of price discrimination
Policy applications and implications
When is price discrimination beneficial and when harmful?
Price discrimination in taxation and social policy
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Perfect price discrimination
Welfare optimality and first-degree discrimination
Practical barriers to first-degree discrimination
The idea of first-degree price discrimination
First-degree price discrimination is ideal?
1
Charge every person personalized price
2
Different price for each unit sold
3
Match everything exactly to willingness-to-pay
Capture full surplus consumers gain
Rarely observed in real world (theoretical benchmark), but
1
Bargaining institution with very competent bargainer
2
Personalized pricing systems on the internet
3
CVS coupon systems
Best possible thing for monopolist, gets everything
Therefore companies are always looking for better ways
But terrible for consumers, gain no surplus
But what about total social value?
Very attractive in many dimensions
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Perfect price discrimination
Welfare optimality and first-degree discrimination
Practical barriers to first-degree discrimination
Graphical illustration of 1st degree discrimination
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Perfect price discrimination
Welfare optimality and first-degree discrimination
Practical barriers to first-degree discrimination
Efficiency of first-degree price discrimination
First-degree price discrimination is highly efficient
In fact, as efficient as perfect competition
Every consumer willing to pay above cost served
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Can’t make anyone pay more than worth to them
So charge them exactly that, for each unit
Anytime willing-to-pay above cost, profit available
Thus monopoly sells efficiently
Why does 1st degree discrimination do so well?
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2
3
Selling more doesn’t require lowering price
Seller can capture full value created
Thus tries to maximize value created
However, seller captures all value
Consumers gain no surplus
=⇒ Distributive issues important objection
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Perfect price discrimination
Welfare optimality and first-degree discrimination
Practical barriers to first-degree discrimination
Distributive objections and (partial) solutions
Thus perfect price discrimination often unpopular
But more efficient...so should be possible to redistribute
Economists advocate pairing with redistributive method
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Bidding for right to monopoly (franchise)
2
Profit taxes
3
Labor unions
Government auction, captures all profits for other things
Government taxes away profits, distributes as pleases
Unions extract profits as higher wages
None of these solutions as perfect as it sounds
Redistributive authority, competitor needs to know profits
Also may be benefits not to redistributing
Allows firm to capture full value created (Lecture 13)
Lessons apply to broader price discrimination
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Perfect price discrimination
Welfare optimality and first-degree discrimination
Practical barriers to first-degree discrimination
Information and barriers to perfect discrimination
Whatever its merits, first-degree discrimination difficult
This is why we rarely see it in practice
Barriers to implement include?
1
Administrative and “menu” costs
Requires quoting different price to consumers
Could they even process this? Predict? Plan?
2
Fairness constraints
Many people think that price discrimination is unfair
Can alienate consumers
3
Arbitrage and keeping track of consumers
If one consumer can easily resell, undermines system
4
Information about willingness to pay
Most important, how to know what to charge each?
Fundamentally, distortion because monopolist uniformed
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Perfect price discrimination
Welfare optimality and first-degree discrimination
Practical barriers to first-degree discrimination
Examples of impracticality of perfect discrimination
To see why these are problems, consider some cases:
1
Prescription drugs, books and arbitrage?
Drug companies, publishers charge less in poor countries
Proved very problematic: reimportation (legal or illegal )
Also resentment leads to price controls in rich world
Think of how much worse if you tried to slice up countries!
2
Credit card surcharges and fairness?
Merchants charged for accepting credit cards
Would like to pass on to consumers, but resented
Legal restrictions too, but how much worse personalized!
3
Haggling and information?
Anyone in a bazaar knows it doesn’t always work
Because no one knows other’s value strategic postures
=⇒ Even with face-to-face, first-degree very hard
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Quantity discounts and surcharges
Variable quality
Other discriminatory strategies
Non-linear pricing and quantity discounts (surcharges)
Thus, in practice, price discrimination much less perfect
One way firms commonly do this is non-linear tariffs
Different prices for different numbers of units
Often choice of different discrete bundles
Examples of this (typically discount) abound?
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Bulk discounts in commercial goods
Punch cards for loyal customers
New York Times: free for 20 articles, charge after that
Pricing of cloud file-sharing services
Income taxes: rates vary depending on income level
Goal: consumers self-select into right price
Lower price if they don’t mind storing, keeping track of card
Lower price to those who don’t value enough to use often
=⇒ Not as effective, as must incentivize limited cheating
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Quantity discounts and surcharges
Variable quality
Other discriminatory strategies
Graphical illustration of non-linear pricing
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Quantity discounts and surcharges
Variable quality
Other discriminatory strategies
Qualities of service and multiple products
Can offer not just different quantities but also qualities
This is very common strategy?
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Classes of service in airlines
Qualities of rooms at a hotel
Different levels of American Express card
Tiers of cable and internet service
Common observation: low-quality deliberately degraded
Not that the airline can’t offer better service
Deliberately makes Coach experience bad
This forces those who can to pay for business, first
Thus monopolist distorts quality as well as quantity
Particularly large for low-end customers
Less reason to make first-class worse
We’ll return to these issues in Lecture 14
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Quantity discounts and surcharges
Variable quality
Other discriminatory strategies
Graphical illustration of quality-based discrimination
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Marginal WTP
5
High quality demand
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3
2
1
0
0.0
Low quality demand
0.5
1.0
Weyl (Fall 2011)
1.5
2.0
Price Discrimination
2.5
Quality 3.0
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Quantity discounts and surcharges
Variable quality
Other discriminatory strategies
Bundling, two-part tariffs and efficiency
Price discrimination takes related (more specific) forms
Some of these achieve efficiency just like perfect
Also transfer all value to the monopolist
1
Bundling: two products cheaper together than apart
Two pieces of software free to produce: Excel and Word
Some people like Excel better, some Word
Values for the package much more homogeneous
Then monopolist can capture much more value in package
=⇒ Packaging/bundling clarifies information
2
Extreme form is “two-part tariff”
Extreme form of bundling; charge for right to buy
Low pricing for various services, near (or below) cost
Rides at Disneyland, Costco, Rhapsody, etc.
Achieves efficiency, but takes all from consumers
=⇒ Just like perfect price discrimination (information perfect)
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Quantity discounts and surcharges
Variable quality
Other discriminatory strategies
Loyalty, sales and add-ons
Other forms of discrimination less perfect, efficient
1
Loyalty and personalized discounts
CVS and others track your purchasing
Offer targeted discounts based on purchasing behavior
Helps get closer to perfect, but incentives to manipulate
2
Inter-temporal (sales)
Department, outlet stores’ periodic sales/discounts
Those whose demand is time-sensitive willing to pay a lot
Thus discriminate by offering less to those willing to wait
Airline ticket and hotel room pricing similar
3
Add-ons and obfuscation
Hotels, printers, banks and others cheap to get into
But soak you for lots of extras once you are on board
=⇒ Discriminate against those who don’t read small print
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Quantity discounts and surcharges
Variable quality
Other discriminatory strategies
Master of the House
One of my favorite examples is from Les Miserables:
Inn keeper Thenardier describes his pricing policies
Reasonable charges
Plus some little extras on the side!
Charge ’em for the lice, extra for the mice
Two percent for looking in the mirror twice
Here a little slice, there a little cut
Three percent for sleeping with the window shut
When it comes to fixing prices
There are a lot of tricks he knows
How it all increases, all them bits and pieces
Jesus! It’s amazing how it grows!
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Quantity discounts and surcharges
Variable quality
Other discriminatory strategies
When are prices discriminatory?
Some of these practices can be explained by costs
1
Peak-load pricing leads to variation across time
Little marginal cost of movie tickets when not full
Very valuable during rush times
2
May be cheaper to sell goods in bundles
Most of cost of software is the CD; cheaper to put together
3
Some populations cheaper to serve than others
Different prices for different insurance risks
Senior citizens less disruptive to other movie watchers
Then what makes something price discrimination?
1
Different prices reflect demand not cost conditions
This would never happen in competitive market
Efficiency variation even more likely in competitive
2
Lack of variation when costs vary just as discriminatory
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Third-degree price discrimination
Effects of third-degree discrimination
Taxation, tagging and price discrimination
Explicit price discrimination
Another, imperfect, approach is to group people
Use some objective characteristic
Charge different prices to people with these characteristics
=⇒ Charge higher prices to those with more elastic demand
Most commonly used in entertainment, transportation?
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Senior, student and other discounts
Library surcharges for journals
Educator and public servant discounts
Prescription drug pricing in developing world
Home and office software licensing
Unemployment insurance, height tax and other tagging
More on this below
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8
Resident and tourist pricing in public services
Discounting menus in foreign languages (Chinese)
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Third-degree price discrimination
Effects of third-degree discrimination
Taxation, tagging and price discrimination
A mathematical example of explicit price discrimination
Demand Q H (p) = 1 −
p
2
“High” market, Q L (p) = 1 − p “Low”
Assume 0 marginal cost of production
?
?
Discriminatory prices half of maximum: pH = 1, pL =
Pooled demand kinked?
For p < 1, 2 −
3p
2 ,
for p > 1, 1 −
p
2
Optimal from first segment is half way up: p? =
Compare profits from two points?
1·
2
3
=
2
3
v. 1 ·
1
2
=
1
2
=⇒ p? =
1
2
2
3
2
3
Is discrimination good or bad?
Output is same: 1 in either case
But SS without is 32 · 1 · 12 + 23 = 1, with is
1 · 21 · 21 + 12 · 12 · 12 + 12 + 12 · 12 = 15
16 < 1; why?
High market values more, lose more of that than gain in low
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Third-degree price discrimination
Effects of third-degree discrimination
Taxation, tagging and price discrimination
Possible effects of third-degree discrimination
So we found output unaffected, welfare and CS down
Obviously very special: both demands linear
Properties hold generally for linear if both markets served
More broadly:
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If both markets served, output may go up or down
Welfare may go up or down
CS may go up or down
If High served without discrimination, pure benefit
Everything depends on pass-through rates:
The bigger PT is in Low v. High, better is discrimination
Threshold smallest for output, then welfare, then CS
Mark-up higher in High, profits rise so CS harder
=⇒ In principle, discrimination can be good or bad
Only consistent is redistribution from High to Low
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Third-degree price discrimination
Effects of third-degree discrimination
Taxation, tagging and price discrimination
Likely effect of third-degree discrimination
This paints a bit of a complicated picture
But results are a bit puzzling
Everything seems ambiguous, depends on details
But we know perfect price discrimination...
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2
Produces more and is more socially efficient
Reduces consumer surplus
We can also get to perfect by many 3rd-degree
Slice up market once, then slice up submarkets, etc.
=⇒ Any given 3rd-degree ambiguous, eventually clear
Suggests that “typical” slicing of demand falls in right way
Simple example:
Segment for everyone willing-to-pay above/below x
If x < p don’t change in high, serve low, good for all
If x > p serve all in high, drop price in low
=⇒ Welfare increases every step, likely more accurate
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Third-degree price discrimination
Effects of third-degree discrimination
Taxation, tagging and price discrimination
Ideal lump sum taxes and height tax proxy
On Tuesday, we’ll talk lots about redistributive taxation
But basic goal is much like monopoly:
1
Want to raise revenue to redistribute
From each according to ability...
2
But tax on everyone discourages work, lowers revenue
Could solve if you knew everyone’s ability to earn
Just charge them this, don’t worry about discouraging work
Equivalent of perfect price discrimination
Absent this, use imperfect forms of price discrimination
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Find categories to put people
Charge higher taxes to those with greater earning potential
Allows more redistribution without high taxes on margin
Exactly the same logic as 3rd-degree discrimination!
Obvious category height: easy to observe, hard to change
Data shows tall earn more! Should we be taxing height?
Weyl (Fall 2011)
Price Discrimination
First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Third-degree price discrimination
Effects of third-degree discrimination
Taxation, tagging and price discrimination
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Weyl (Fall 2011)
Price Discrimination
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First-Degree Discrimination
Second-Degree Discrimination
Third-Degree Discrimination
Third-degree price discrimination
Effects of third-degree discrimination
Taxation, tagging and price discrimination
Broader forms of tagging
More broadly (and seriously) trade-off key in policy
One hand: don’t want to distort decisions, tax directly
Other: if clear, price discriminations tells us to use
Many areas of public policy can be interpreted in this way
1
Affirmative action and racial preferences
Basing too much on income may discourage parental work
Cannot change their race, minorities poorer on average
=⇒ Price discrimination suggests favorable treatment
2
Complicated tagging and deductions in taxes
Aid to handicapped, single mothers, unemployed, etc.
If people cannot easily adjust, useful “tag” for discrimination
=⇒ Economists should not instinctively oppose
While seems to violate equity, 2nd welfare theorem...
Actually just follow from logic of price discrimination
Weyl (Fall 2011)
Price Discrimination